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Edited Transcript of ARR earnings conference call or presentation 26-Oct-17 2:00pm GMT

Thomson Reuters StreetEvents

Q3 2017 ARMOUR Residential REIT Inc Earnings Call

VERO BEACH Oct 30, 2017 (Thomson StreetEvents) -- Edited Transcript of ARMOUR Residential REIT Inc earnings conference call or presentation Thursday, October 26, 2017 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* James R. Mountain

ARMOUR Residential REIT, Inc. - CFO, Treasurer and Secretary

* Jeffrey J. Zimmer

ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO and President

* Mark R. Gruber

ARMOUR Residential REIT, Inc. - COO and Head of Portfolio Management

* Scott J. Ulm

ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO, CIO and Head of Risk Management

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Conference Call Participants

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* Christopher Whitbread Patrick Nolan

Ladenburg Thalmann & Co. Inc., Research Division - Research Analyst

* Joshua Hill Bolton

Crédit Suisse AG, Research Division - Research Analyst

* Trevor John Cranston

JMP Securities LLC, Research Division - Director and Senior Research Analyst

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Presentation

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Operator [1]

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Good morning, and welcome to the ARMOUR Residential REIT, Inc. Third Quarter 2017 Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I would now like to turn the call over to Mr. Jim Mountain, Chief Financial Officer of ARMOUR Residential REIT, Inc. Please go ahead, sir.

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James R. Mountain, ARMOUR Residential REIT, Inc. - CFO, Treasurer and Secretary [2]

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Thank you, operator. And thank you all for joining ARMOUR's Third Quarter 2017 Earnings Call. By now everyone has access to ARMOUR's earnings release and Form 10-Q, which can be found on ARMOUR's website. This conference call may contain statements that are not recitations of historical fact and, therefore, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the safe harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from the outcomes and results expressed or implied by these forward-looking statements due to the impact of many factors beyond the control of ARMOUR. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of ARMOUR's periodic reports filed with the Securities and Exchange Commission. Copies of these statements are available on the SEC's website at www.sec.gov. All forward-looking statements included in this conference call are made only as of today's date and are subject to change without notice. We disclaim any obligation to update our forward-looking statements unless required by law.

Also, our discussions today may include references to certain non-GAAP measures. A reconciliation of these measures to the most comparable GAAP measures is included in our earnings release, which can be found on ARMOUR's website. An online replay of this conference call will be available on ARMOUR's website shortly and will continue for 1 year.

ARMOUR's third quarter GAAP net income was $27.7 million or $0.58 per common share. Core earnings were $32.6 million or $0.69 per common share, that represents an annualized return on equity of 10.1% based on book value at the beginning of the quarter. Differences between GAAP and core income are mostly due to the treatment of TBA dropped income and unrealized gains on our interest rate contracts. ARMOUR does not use hedge accounting for GAAP reporting, and fluctuations in the fair value of our open interest rate swaps is a dominant factor in GAAP income, while the inversely related mark-to-market on our Agency Securities flows directly into shareholders' equity.

We paid dividends of $0.19 per common share during each month of Q3 for a total of $23.5 million or $0.57 per common share for the quarter. Tomorrow, we will also pay common dividends of $0.19 per share for October, and we have announced November common dividends of $0.19 per share for shareholders of record as of November 15, 2017, which will be payable on November 27, 2017.

At September 30, 2017, ARMOUR's book value was $26.68 per common share, up 1.1% over the quarter. As a reminder, we include updated estimates of our book value per share on our monthly company updates available on our website, www.armourreit.com.

ARMOUR's quarter-end portfolio consisted of $7.1 billion of Agency Securities, plus another $1.9 billion of agency TBA positions. Our CRT positions totaled $0.9 billion as of September 2017. These positions saw some temporary widening at the end of the quarter on initial hurricane concerns. But as the market digested the news, those spreads have come back in this month. Our mortgage-backed securities portfolio was financed with approximately $7.2 billion of borrowings under repo agreements. ARMOUR's interest rate hedge position totaled $5.1 billion of notional coverage at the end of September.

With these highlights, now I'd like to turn the call over to our Co-Chief Executive officers, Scott Ulm and Jeff Zimmer, to discuss ARMOUR's portfolio position and current strategy in more detail.

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Scott J. Ulm, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO, CIO and Head of Risk Management [3]

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Thanks, Jim. Good morning, everyone. In addition to the customary SEC filings, we also continue to provide a company update, which is furnished to the SEC and available on EDGAR as well as our website. The company update contains a considerable amount of information about our portfolio, our hedge book and our repo financing book. These company updates, along with the comments we make during our earnings call, provide our shareholders and analysts with substantial information on the state of the company. Thus, the quarterly financial report we filed last night should contain few surprises for any of our listeners today.

ARMOUR realized total shareholder return of approximately 10%, including reinvested dividends, and total economic return of 3.2% for the third quarter of 2017, not annualized. Additionally, core income exceeded dividends declared and paid, as it has for the last 5 quarters. Our book value increased by 1.1% during the third quarter. As of October 23, our book value was $26.48, down 0.7% since the end of the third quarter.

Our funded leverage ratio is 5.5 to 1. Adding our unfunded TBA positions results in leverage of 7.0 to 1. We continue to see value in sectors of the agency market. These leverage ratios and our liquidity leave us with some dry powder to take advantage of further compelling investment opportunities, should they appear.

The prepayment rate on our agency assets increased during the quarter from 7.0 CPR in the second quarter to 7.1 CPR in the third quarter. Our portfolio paid 6.2 CPR in October. Please note that a good portion of our agency portfolio, excluding TBA, is composed of assets with prepayment protection through lower loan balances or contractual prepayment lockouts.

Our notional swap position has decreased from $5.2 billion at the end of the second quarter to $5.1 billion at the end of the third quarter. Repo financing remains consistent and reasonably priced for our business plan.

ARMOUR maintains MRAs with 46 counterparties and is currently active with 28 of those for a total financing of $7.2 billion at the end of the third quarter.

In addition, our affiliate BUCKLER Securities became operational during the early part of the fourth quarter. Financing through BUCKLER is expected to provide us greater security of financing as well as contribute to a lower cost of funds.

The agency portfolio is comprised of 6 major components, not including the TBA dollar rolls. At the end of the quarter, 50.4% of our agency portfolio was comprised of 25- and 30-year maturity fixed rates among, currently maturing between 24 -- 241 and 360 months. 35.7% have a $175,000 loan balance or less. 19.3% of our agency portfolio was comprised of 15-year final maturity pass-throughs, with a weighted average seasoning of 72 months. 24.6% of those 15-year pass-throughs had loan balances less than or equal to $175,000. 25.9% of our agency portfolio was comprised of Fannie Mae multifamily bonds or DUS, which stands for delegated underwriting and servicing bonds. The DUS bonds we own are generally locked out from prepayments for the first 9.5 years of their 10-year expected maturity. Any prepayment penalties received due to early payoffs can enhance the yield on the bonds. At the end of the third quarter, our DUS bonds had a weighted average maturity to the end of the lockout period of 6.6 years. The bullet-like maturity of these assets means they roll down the curve over time, much like a corporate bond or treasury note, providing great potential to trade tighter, particularly as they approach benchmark areas like the 5-year treasury note.

In addition, these bonds are subject to an early redemption penalty, which enhanced ARMOUR's returns in the second quarter by $0.03. We did not have any benefit of a substantial DUS redemption penalties in the third quarter.

Our $69.9 million ARM position, 1% of our agency assets, had a weighted average reset of 9 months. At the end of the third quarter, we had dollar rolls with a net notional value of $1.9 billion. We continue to see certain TBA dollar rolls at very attractive levels versus owning and financing bonds. We actively monitor the attractiveness of risks and return in dollar rolls and may increase or decrease this position depending on market conditions.

We believe that our current investments in nonagency assets will provide attractive and stable returns going forward, enable us to operate at a lower leverage multiple and reduce the risks associated with swaps. Our equity allocation to nonagencies is approximately 40%. As a bright-line statistic, we define that equity allocation as the percentage of our equity tied up in haircuts for repo. While gross portfolio allocations will show a much larger [count of agencies] on our balance sheet, we think the purest way to think about capital allocation is equity committed to financing haircuts in each sector. Equity that's not tied up in financing haircuts is our liquidity, and that liquidity is available to support any part of the portfolio.

ARMOUR's credit risk transfer securities, or CRTs, were valued at $856.3 million at the end of the third quarter and represented 88.6% of our nonagency portfolio. We have been rewarded both by the spread tightening that has occurred in this sector over the last 18 months and by the attractive carry. Our weighted average CRT coupon as of the end of the third quarter was 5.7%, with a weighted average margin of 4.5%.

In the CRT transactions, we take the credit risk of recent Fannie and Freddie underwriting in return for an uncapped floating rate coupon. Strong mortgage underwriting and up-trending housing prices have provided a robust underpinning to the credit quality of the CRT bonds. In addition, these securities benefit from increasing credit enhancement over time that can lead to credit rating upgrades. One of our securities has been upgraded to investment-grade, and we feel several other securities in the portfolio will be candidates for upgrades in the near future.

The recent hurricanes also provided a test of the resilience of these securities to natural disasters. The securities initially widened in spread after the hurricanes. But as loss assessment improved, spreads tightened again to today's historically tight levels.

At the end of the third quarter, ARMOUR owned $91 million of nonagency legacy MBS. Today, we see very few opportunities for investment in the 2008 and prior nonagency MBS asset class. All of our existing assets from that period continue to perform well as they run off. Like many market participants, we continue to hope for a revival in the jumbo securitization market. While we've owned more significant amounts in the past, our new issued jumbo MBS exposure is only $19.1 million.

Our principal concerns for the fourth quarter are the familiar issues of rates, spreads and prepayments. The Fed's tapering of reinvestment is underway, and so far, seems to have minimal impact on the mortgage market. Though, that could well change as reinvestment lessens over the coming months and net supply increases. In addition, we have leadership decisions for the Fed, which will likely affect the market's tone as well as policy. We expect another Fed hike in December. Higher rates going into this quarter will likely temper prepayments. The U.S. economy continues to make progress if the stock market is any indicator, but we expect the growth to continue at a relatively modest pace. The Trump administration's policy hold the potential for both positive and negative effects on our operations. We'll position the portfolio and our hedging to reflect this assessment of heightened risks while still allowing us to earn our dividend, which we feel is sustainable based on current investment opportunities and funding rates.

Operator, that concludes our prepared remarks. We'll now take any questions. Thank you.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from the line of Trevor Cranston with JMP Securities.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [2]

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First question on -- with BUCKLER Securities coming online in the fourth quarter, can you give some additional color on sort of the rates you expect to be able to achieve through BUCKLER versus what you get more traditionally through tri-party repo? And also, what the goal is over the next couple of quarters in terms of how much of your financing you think you'll be able to do through BUCKLER?

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO and President [3]

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Hi, Trevor, it's Jeff. So in the last conference call, I believe we quoted, we ultimately hope to save in the 5 to 7 basis point range once we get them fully on boarded. Our goal right now, based on the size of our portfolio, is to initially go to $3 billion of our $7.2 billion of financing. And at that point, the ARMOUR board and the management will sit down and see if we want to increase from there. But look, that’s not a panacea. We have BUCKLER because it provides safety and soundness of financing. It's not just about saving a handful of basis points or perhaps more. We spent 20 months getting that operation going. And finally, within the last week or so did we do our first transaction. So it'll take some time to get up to $3 billion. I didn't know that we'll achieve that by the end of the year, but certainly in the first quarter.

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Trevor John Cranston, JMP Securities LLC, Research Division - Director and Senior Research Analyst [4]

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Great. And then second question on -- you mentioned in the prepared remarks towards the end that you guys are sort of watching and monitoring the effect that the Fed's balance sheet taper and then the potential announcement of a new Chairman. What's the impact that might have on spreads in the market? Can you talk about how you sort of view the balance between what you guys view as the incremental returns on investing in agencies versus the potential downside risk if we were to get some spread-widening pressure in that sector?

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO and President [5]

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Sure. So there's a couple of ways to look at this. Let's look at it globally. Relative to other assets classes, mortgages on a levered basis look darn cheap. However, if I look at my OAS charts, from the end of 2016 to now, OAS have come in almost by 40%. By the -- from the end of June, they have come in by about the same amount. So they have tightened. Now they've tightened in an environment where everybody knows that the Fed is now going to reduce the amount of their reinvestment, starting with $4 billion for the first quarter then $8 billion and on through the end of 2018. We believe that you're going to have to have a new set of buyers come in to see mortgages get substantially tighter from here. But in that regard, we would expect mortgages to be flat to wider when we talk a quarter from now and certainly, perhaps, 2 quarters from now. That should provide some good reinvestment opportunities for marginal cash. There've been a number of capital raises, including us over the last 4 to 6 months. Those -- that reinvestment was done not dilutive to current earnings, and we believe we could reinvest marginal capital right now. So it is not dilutive to our current earning stream. Albeit, with the Federal funds expected to increase in December, your funding is going to go up 25 basis points. So in theory, all things being equal, you have to see opportunities in an investment world that will equal that farther out on the curve. In terms of 2 asset classes that we look at closely for reinvestment, one area we think is very overvalued, which is the high pay-up story. Taking specified bonds and paying a blot if you -- anybody who follows mortgages can see that pay-ups has been on a trajectory upward over the last couple of quarters despite the fact that rates have gone up. So we're not quite understanding that, and we're not reinvesting in that area. We're taking advantage of some low pay-up stories, unspecifieds, where it's hard to refinance but the cost to us as an investor is quite low. And remember, you're in a [sanguine] prepayment period, so there is no reason to pay a lot for assets that might perform better in a rally.

Regarding dollar roll market, which we look at a lot, it does provide low double-digit returns. And depending on the asset, the 30 years particularly, anywhere from 12 to 13 in a quarter, let's say, over the next 30 to 60 days, and those are gross that -- and the way we look at that is we're hedged out through 1 duration. So that is a hedge with financing included in that development. So we have been using dollar rolls to add to the value and income of ARMOUR. I hope that answers your question.

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Operator [6]

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(Operator Instructions) And our next question comes from the line of Douglas Harter with Crédit Suisse.

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Joshua Hill Bolton, Crédit Suisse AG, Research Division - Research Analyst [7]

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This is actually Josh on for Doug. Just a follow-up to Trevor's question on BUCKLER Securities. You mentioned that $3 billion is the near-term target or breakeven amount from that source. Can that include both agency and nonagency repo? And also, how do you think about target levels from a risk-management perspective on funding?

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO and President [8]

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So it only includes agencies and will only include agencies. The funding for our nonagencies is expanding exponentially, particularly on our CRTs, from 2 or 3 funding providers to a dozen funding providers now. And they're beating each other up every day with a lower haircut, particularly on the European ones that can go under 25% and lower cost of funds versus LIBOR. So we're actually really happy with what's going on, on the nonagency side.

In terms of risk management, we feel very secure having a good tight eye on what's going on with our own financing. We're very happy to go up to 40% to 45% with $3 billion initially. Will that exceed 50%? It could. But we will get to what our goal is, and we'll analyze and talk to the board and work with our management to see where we stand right there.

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Operator [9]

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And our next question comes from the line of Christopher Nolan with Ladenburg Thalmann.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - Research Analyst [10]

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On the income statement, I'm just looking at the Agency Securities and the TBA drop income, which is up quarter-over-quarter. And can you give a little color in terms of what's driving that increase for each, please?

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Mark R. Gruber, ARMOUR Residential REIT, Inc. - COO and Head of Portfolio Management [11]

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This is Mark. So the TBAs are going to -- the income that's [driver] there is going to be different each quarter based on the opportunities we see. Sometimes during a quarter, we see some opportunities that's something short-term, there are something goes really special or maybe someone's looking to do something and we'll take opportunities against that. It's hard to predict what that's going to look like quarter-over-quarter just because there are so many variables going on in the day-to-day on that. We try to maintain a certain balance, but the differences quarter-over-quarter or if the balances remain the same, there's just going to be opportunities we see for short term (inaudible).

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO and President [12]

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But sometimes you might do an October to November roll, and all of a sudden, the no [Ds] roll doesn't look good, so you can take delivery or sell the asset. So the snapshot you're seeing, the 630 snapshot or the 930 snapshot, do not contemplate what happened in the 90 days during that period.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - Research Analyst [13]

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All right. And then for the Agency Securities loan?

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Scott J. Ulm, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO, CIO and Head of Risk Management [14]

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So what -- agency Securities, the biggest driver during the quarter is going to be prepayments fees on amortization. That was the biggest driver for improvement.

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO and President [15]

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Our prepays have been low and that just represents the quality of -- or the collateral. Like for example, the DUS bonds just don't prepay. And if they do, you get, as we -- as Scott noted earlier, you get a check. When those prepay, there's a penalty to the borrower. Our low loan balance assets have exhibited very good prepayment characteristics as well as -- quite frankly, a good portion of our portfolio has exhibited good prepayment characteristics. It's kept our amortization expense quite low, and obviously, adding to earnings over the last 3 quarters.

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Scott J. Ulm, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO, CIO and Head of Risk Management [16]

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As Jeff said earlier, we will take delivery of TBA. So you'll see -- some income will move between those 2 lines.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - Research Analyst [17]

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Got it. And then I saw that you guys have been issuing common in the -- during October. Is that reflecting the ATM?

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James R. Mountain, ARMOUR Residential REIT, Inc. - CFO, Treasurer and Secretary [18]

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This is Jim. And actually, the common issuances that we have been doing are under our dividend-reinvestment program that allows investors that are interested in ARMOUR stock to apply to purchase it directly from our transfer agent at a modest discount to volume-weighted average price for the day. We had an investor that wanted to buy up a little position over the tail end of September and the first few days in October. And one of the things we like about that program is it allows us to accommodate particular investor interest, but it allows us to do it at a very cost-effective basis for issuing capital. And because it's based on volume weighted-average price for the day, it's not disruptive in the marketplace. It's a little bit, not a ton. And the other thing that is -- because it's cost effective and well priced that is accretive to book value. We have the opportunity, when it looks like markets are trading off, to suspend the program. So we don't -- we're not required to issue under the program at [whatever be] not accretive to existing shareholders.

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Christopher Whitbread Patrick Nolan, Ladenburg Thalmann & Co. Inc., Research Division - Research Analyst [19]

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Great. And final question, Jim, or for anyone. Leverage ratios, your leverage ratios are fairly low. Can you give a little color in terms of where those could go in the next quarter or 2?

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO and President [20]

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So over the last 18 months, the substantial driver of the reduction in our leverage is the addition of the $860 million current value of CRT bonds that we own. For every one of those we've purchased, we've reduced our agencies anywhere from 3.5 to 4.5x. So we don't anticipate at today's spreads adding more of that asset class. I think the last purchase we made was more like 432 basis points rather than today's 232 basis points. So I would expect our leverage to stay within half a turn, at least for the foreseeable future where it is right now. And we ended 5.5 on that 30 and 7. On November 15 approximately, we will put out the end of October monthly company update, so any changes from the end of the quarter till the end of October will be identified in that filed document.

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Operator [21]

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And there are presently no further questions. I'll turn the call back to you for your closing remarks.

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Jeffrey J. Zimmer, ARMOUR Residential REIT, Inc. - Co-Vice Chairman, Co-CEO and President [22]

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Well thank you, everybody, for joining us today. I would note that the REIT sector has performed extraordinarily well this year. Average of the 16 peer groups are -- have total shareholder returns of 19% this year, that's better than S&P's and getting closer to what the NASDAQ did. So it's been a very good place for shareholders to be through yesterday's close, October 25. And we continue to be very positive on long-term investment opportunities and of ARMOUR REIT. Please feel free to call any of us directly at the office and we'll get back to you with any questions, and have a great day.

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Operator [23]

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Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.